MULTINATIONAL FINANCIAL MANAGEMENT

Ram Krishna Khatiwada

WHAT IS YOUR VIEW? A. Why many multinational like Teliasonera, Cocacola, Pepsi, KFC, Uliliver etc. entered in Nepal ?

B. SN Power, a multinational power developer, has already running one hydropower generation unit in Nepal and try to start another unit. The planned project has IRR of more than 18% whereas the IRR at developed country has less than 8%. Despite having better return, SN Power is very cautious to invest in Nepal. What may be the reasons?

CHAPTER OBJECTIVES

To identify the main goal of the multinational corporation (MNC) and potential conflicts with that goal;

To describe the key theories that justify international business; and

To explain the common methods used to conduct international business.

Multinational Corporation (MNC)

Foreign Exchange Markets

Product Markets Subsidiaries International Financial Markets

DividendRemittance& FinancingExporting

& ImportingInvesting

& Financing

THE INTERNATIONAL FINANCIAL ENVIRONMENT

GOAL OF THE MNC

The commonly accepted goal of an MNC is to maximize shareholder wealth.

We will focus on MNCs that wholly own their foreign subsidiaries.

Financial managers throughout the MNC have a single goal of maximizing the value of the entire MNC.

CONFLICTS WITH THE MNC GOAL When a corporation’s shareholders differ from its managers, a conflict of goals can exist—the agency problem.

Agency costs are normally larger for MNCs than for purely domestic firms, due to: the difficulty in monitoring distant managers the different cultures of foreign managers the sheer size of the larger MNCs, and the tendency to downplay short-term effects.

Subsidiary managers may be tempted to make decisions that maximize the values of their respective subsidiaries.

CONFLICTS WITH THE MNC GOAL

IMPACT OF MANAGEMENT CONTROL The magnitude of agency costs can vary with the management style of the MNC.

A centralized management style reduces agency costs. However, a decentralized style gives more control to those managers who are closer to the subsidiary’s operations and environment.

CENTRALIZED MULTINATIONAL FINANCIAL MANAGEMENT

for an MNC with two subsidiaries, A and B

FinancialManagersof Parent

Capital Expendituresat A

Inventory andAccounts

ReceivableManagement at A

CashManagement

at A

Financing at A

Capital Expendituresat B

Inventory andAccounts

ReceivableManagement at B

CashManagement

at B

Financing at B

DECENTRALIZED MULTINATIONAL FINANCIAL MANAGEMENT

for an MNC with two subsidiaries, A and B

FinancialManagers

of A

Capital Expendituresat A

Inventory andAccounts

ReceivableManagement at A

CashManagement

at A

Financing at A

Capital Expendituresat B

Inventory andAccounts

ReceivableManagement at B

CashManagement

at B

Financing at B

FinancialManagers

of B

IMPACT OF MANAGEMENT CONTROL

Some MNCs attempt to strike a balance – they allow subsidiary managers to make the key decisions for their respective operations, but the parent’s management monitors the decisions.

Today, electronic networks make it easier for the parent to monitor the actions and performance of its foreign subsidiaries.

IMPACT OF CORPORATE CONTROL Various forms of corporate control can reduce agency costs: stock options

hostile takeover threat

investor monitoring

CONSTRAINTS INTERFERING WITH THE MNC’S GOAL

MNC managers are confronted with various constraints:environmental constraintsregulatory constraintsethical constraints

A recent study found that investors assigned a higher value to firms that exhibit high corporate governance standards and are likely to obey ethical constraints.

5-14

MERCANTILE THEORY

Mercantilism suggests that it is in a country’s best interest to maintain a trade surplus -to export more than it imports advocates government intervention to achieve a surplus in the balance of trade

Mercantilism views trade as a zero-sum game - one in which a gain by one country results in a loss by another

5-15

THEORY OF ABSOLUTE ADVANTAGE Adam Smith argued that a country has an absolute advantage in the production of a product when it is more efficient than any other country in producing it countries should specialize in the production of goods for which they have an absolute advantage and then trade these goods for the goods produced by other countries

5-16

HOW DOES THE THEORY OF ABSOLUTE ADVANTAGE WORK Assume that two countries, Ghana and South Korea, both have 200 units of resources that could either be used to produce rice or cocoa

In Ghana, it takes 10 units of resources to produce one ton of cocoa and 20 units of resources to produce one ton of rice Ghana could produce 20 tons of cocoa and no rice, 10 tons of rice and no cocoa, or some combination of rice and cocoa between the two extremes

In South Korea it takes 40 units of resources to produce one ton of cocoa and 10 resources to produce one ton of rice South Korea could produce 5 tons of cocoa and no rice, 20 tons of rice and no cocoa, or some combination in between

5-17

HOW DOES THE THEORY OF ABSOLUTE ADVANTAGE WORK

Without trade Ghana would produce 10 tons of cocoa and 5 tons of rice South Korea would produce 10 tons of rice and 2.5 tons of cocoa

With specialization and trade Ghana would produce 20 tons of cocoa South Korea would produce 20 tons of rice Ghana could trade 6 tons of cocoa to South Korea for 6 tons of rice

After trade Ghana would have 14 tons of cocoa left, and 6 tons of rice South Korea would have 14 tons of rice left and 6 tons of cocoa

If each country specializes in the production of the good in which it has an absolute advantage and trades for the other, both countries gain

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HOW DOES THE THEORY OF ABSOLUTE ADVANTAGE WORK

Absolute Advantage and the Gains from Trade

5-19

THEORY OF COMPARATIVE ADVANTAGE

David Ricardo asked what might happen when one country has an absolute advantage in the production of all goods

Ricardo’s theory of comparative advantage suggests that countries should specialize in the production of those goods they produce most efficiently and buy goods that they produce less efficiently from other countries, even if this means buying goods from other countries that they could produce more efficiently at home

5-20

HOW DOES THE THEORY OF COMPARATIVE ADVANTAGE WORK?

AssumeGhana is more efficient in the production of both cocoa and rice

in Ghana, it takes 10 resources to produce one ton of cocoa, and 13 1/3 resources to produce one ton of rice

So, Ghana could produce 20 tons of cocoa and no rice, 15 tons of rice and no cocoa, or some combination of the two

in South Korea, it takes 40 resources to produce one ton of cocoa and 20 resources to produce one ton of rice

so, South Korea could produce 5 tons of cocoa and no rice, 10 tons of rice and no cocoa, or some combination of the two

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HOW DOES THE THEORY OF COMPARATIVE ADVANTAGE WORK?

With tradeGhana could export 4 tons of cocoa to South Korea in exchange for 4 tons of rice

Ghana will still have 11 tons of cocoa, and 4 additional tons of rice

South Korea still has 6 tons of rice and 4 tons of cocoa

if each country specializes in the production of the good in which it has a comparative advantage and trades for the other, both countries gain

Comparative advantage theory provides a strong rationale for encouraging free trade

5-22

HOW DOES THE THEORY OF COMPARATIVE ADVANTAGE WORK?

Comparative Advantage and the Gains from Trade

5-23

PRODUCT LIFE CYCLE THEORY

The product life-cycle theory - (Raymond Vernon) - as products mature both the location of sales and the optimal production location will change affecting the flow and direction of trade the size and wealth of the U.S. market gave U.S. firms a strong incentive to develop new products

initially, the product would be produced and sold in the U.S. as demand grew in other developed countries, U.S. firms would begin to export

demand for the new product would grow in other advanced countries over time making it worthwhile for foreign producers to begin producing for their home markets

5-24

PRODUCT LIFE CYCLE THEORY

U.S. firms might set up production facilities in advanced countries with growing demand, limiting exports from the U.S.

As the market in the U.S. and other advanced nations matured, the product would become more standardized, and price the main competitive weapon

Producers based in advanced countries where labor costs were lower than the United States might now be able to export to the United States

If cost pressures were intense, developing countries would acquire a production advantage over advanced countries

Production became concentrated in lower-cost foreign locations, and the United States became an importer of the product

5-25

PRODUCT LIFE CYCLE THEORY

The Product Life Cycle Theory

2. Firm exports product to accommodate foreign demand

1. Firm creates product to accommodate local demand

THE INTERNATIONAL PRODUCT LIFE CYCLE

3. Firm establishes foreign subsidiary to establish presence in foreign country and possibly to reduce costs

4a. Firm differentiates product from competitors and/or expands product line in foreign country

4b. Firm’s foreign business declines as its competitive advantages are eliminated

or

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DOES THE PRODUCT LIFE CYCLE THEORY HOLD?

The product life cycle theory accurately explains what has happened for products like photocopiers and a number of other high technology products developed in the United States in the 1960s and 1970s

But, the globalization and integration of the world economy has made this theory less valid todayproduction today is dispersed globallyproducts today are introduced in multiple markets simultaneously

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WHAT ARE THE IMPLICATIONS OF TRADE THEORY FOR MANAGERS?

1. Location implications - a firm should disperse its various productive activities to those countries where they can be performed most efficiently

firms that do not, may be at a competitive disadvantage

2. First-mover implications - a first-mover advantage can help a firm dominate global trade in that product

3. Policy implications - firms should work to encourage governmental policies that support free trade

firms should lobby the government to adopt policies that have a favorable impact on each component of the diamond

INTERNATIONAL BUSINESS METHODS (1)1. International trade involves exporting

and/or importing.

2. Licensing allows a firm to provide its technology in exchange for fees or some other benefits.

3. Franchizing obligates a firm to provide a specialized sales or service strategy, support assistance and possibly an initial investment, in exchange for periodic fees.

INTERNATIONAL BUSINESS METHODS (2)

4. Firms may also penetrate foreign markets by engaging in a joint venture (joint ownership and operation) with firms that reside in those markets.

5. Acquisitions of existing operations in foreign countries allow firms to quickly gain control over foreign operations as well as a share of the foreign market.

INTERNATIONAL BUSINESS METHODS (3)6. Firms can also penetrate foreign markets

by establishing new foreign subsidiaries.

Many MNCs use a combination of methods to increase international business.

In general, any method of conducting business that requires a direct investment in foreign operations is referred to as a direct foreign investment (DFI).

INTERNATIONAL OPPORTUNITIES (1) Investment opportunitiesThe marginal returns on MNC projects are above those of purely domestic firms since MNCs have expanded opportunity sets of possible projects from which to select.

Financing opportunitiesMNCs can obtain capital funding at a lower cost due to their larger opportunity set of funding sources around the world.

INTERNATIONAL OPPORTUNITIES (2)

Opportunities in Europe the Single European Act of 1987 the removal of the Berlin Wall in 1989 the inception of the euro in 1999 the expansion of the European Union

INTERNATIONAL OPPORTUNITIES (3)

Opportunities in Latin America the North American Free Trade Agreement (NAFTA) of 1993 the removal of investment restrictions

Opportunities in Asia the removal of investment restrictions the impact of the Asian crisis in 1997–1998

EXPOSURE TO INTERNATIONAL RISK International business usually increases an MNC’s exposure to:

1. exchange rate movements

2. foreign economies

3. political risk

OVERVIEW OF AN MNC’S CASH FLOWS (1)

Profile A: MNCs Focused on International Trade

U.S.-based MNC

U.S. CustomersPayments for products

U.S. BusinessesPayments for supplies

Foreign ImportersPayments for exports

Foreign ExportersPayments for imports

OVERVIEW OF AN MNC’S CASH FLOWS (2)

Profile B: MNCs Focused on International Trade and International Arrangements

U.S.-based MNC

U.S. CustomersPayments for products

U.S. BusinessesPayments for supplies

Foreign ImportersPayments for exports

Foreign ExportersPayments for imports

Foreign FirmsFees for services provided

Fees for services received Foreign Firms

OVERVIEW OF AN MNC’S CASH FLOWS (3) Profile C: MNCs Focused on International Trade, International

Arrangements, and Direct Foreign Investment

U.K.-based MNC

U.K. CustomersPayments for products

U.K. BusinessesPayments for supplies

Foreign ImportersPayments for exports

Foreign ExportersPayments for imports

Foreign SubsidiariesFunds remitted back

Foreign FirmsFees for services provided

Fees for services received Foreign Firms

Investment funds Foreign Subsidiaries

n

ttt

k1=

$,

1

CF E = Value

E (CF$,t ) = expected cash flows to be received at the end of period tn = the number of periods into the future in which cash flows are receivedk = the required rate of return by investors

VALUATION MODEL FOR AN MNC (1)

Domestic Model

n

tt

m

jtjtj

k1=

1 , ,

1

ER ECF E

= Value

E (CFj,t ) = expected cash flows denominated in currency j to be received by the U.S. parent at the end of period tE (ERj,t ) = expected exchange rate at which currency j can be converted to dollars at the end of period tk = the weighted average cost of capital of the MNC

VALUATION MODEL FOR AN MNC (2) Valuing International Cash Flows

IMPACT OF FINANCIAL MANAGEMENT AND INTERNATIONAL CONDITIONS ON VALUE An MNC will decide how much business to conduct in each country and how much financing to obtain in each currency.

The MNC’s financial decisions determine its exposure to the international environment.

An MNC can control its degree of exposureto exchange rate effects, economic conditions, and political conditions with its financial management.

ORGANIZATION OF THE TEXT

Background on

International Financial Markets

(Chapters 2–5)

Exchange Rate Behavior

(Chapters 6–8)

Long-Term Investment and

Financing Decisions

(Chapters 13–18)

Short-Term Investment and

Financing Decisions (Chapters 19–21)

Exchange Rate Risk Management (Chapters 9–12)

Risk and Return of

MNC

Value and Stock Price

of MNC

Thank you,

Any Question???